Cost Segregation Study Terms Explained

Cost segregation studies often come packed with complex terminology pulled from tax law, engineering, and construction. For property owners, investors, and even many tax professionals, these terms can seem like a different language altogether. However, grasping these concepts is crucial for understanding a study’s results and applying them accurately on a tax return.

This glossary is designed to simplify the jargon found in your cost seg study.

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Deconstruct Lingo On Your Cost Segregation Study

Below is a list of easy-to-understand definitions of common technical terms and abbreviations you might run into in a cost segregation report, along with some context on how they’re used in real life.

Allocation Factor:

A number used to adjust the unit costs in an estimate so they reflect any discount or premium paid when the taxpayer purchased the property.

Alternative Depreciation System (ADS):

The Alternative Depreciation System is a slower way of depreciating property for tax purposes. Instead of taking bigger deductions in the early years, ADS spreads the cost of the asset evenly over a longer time using the straight-line method. The IRS requires ADS in certain situations, such as when property is used mostly outside the U.S., used for tax-exempt purposes, or when a taxpayer chooses it to avoid depreciation recapture issues.

Asset Classification:

In a cost segregation study, each part of a property is classified as either 1250 property or 1245 property. Section 1250 property is the building itself and anything permanently attached to it, while Section 1245 property includes items that aren’t part of the main structure, such as certain equipment or improvements, which can be depreciated more quickly. The purpose of this classification is to identify as much 1245 property as possible so you can accelerate depreciation.

Bonus Depreciation:

A tax incentive that lets businesses deduct a large percentage (up to 100% in certain years) of an asset’s cost in the first year it’s placed in service, instead of spreading the deduction over many years. Bonus depreciation is often used to accelerate tax savings, improve cash flow, and is commonly applied to qualifying assets identified in a cost segregation study.

Cost Basis:

The original value of an asset for tax purposes, usually the purchase price plus certain costs like improvements, fees, or closing costs. In a cost segregation study, the value of the land is excluded from the depreciable cost basis since land is not depreciable. Cost basis is then used to determine depreciation deductions and calculate any gain or loss when the asset is sold.

Cost Recovery Period:

The IRS gives you a specific number of years to depreciate an asset for tax purposes. Throughout this time, you can recoup the asset’s cost by taking annual depreciation deductions. In a cost segregation study, various parts of a property might have different recovery periods (like 5, 7, 15, or even 39 years) based on how each asset is categorized.

Cost Segregation ATG:

The Audit Techniques Guide (ATG) is a reference manual put out by the IRS to assist its examiners in reviewing and evaluating cost segregation studies. This guide covers the principles, legal background, and methodologies that come into play with cost segregation, while also detailing what the IRS deems as acceptable documentation. It is primarily used by auditors, tax professionals and engineers.

Declining Balance (150DB, 200DB):

The 150% and 200% Declining Balance methods is a way to calculate depreciation. You start by dividing 150% or 200% by the asset's lifespan, then multiply that percentage by the asset's net value to find out how much depreciation you can claim each year. If the amount you calculate using the 150% or 200% declining balance method ends up being lower than what you'd get with the straight line method, you'll switch to the straight line method for the rest of the asset's life.

Depreciation Factor:

An adjustment that reflects the loss in value from wear and tear or outdated features that happened between when the property was originally built and when the taxpayer purchased it.

Direct Cost:

An expense that can be specifically traced to creating or acquiring a particular asset, such as the labor, materials, and equipment used in its construction or production.

Exhibits:

The supporting sections of a cost segregation report that provide detailed backup for the study’s conclusions. These exhibits may include asset class summaries, detailed cost breakdowns, depreciation schedules, technical explanations, and photographs. Together, they document how each asset was classified, its recovery period, applicable depreciation method, and bonus depreciation eligibility, as well as the data, calculations, and visual evidence used to support those classifications.

General Depreciation System (GDS):

General Depreciation System is the primary IRS depreciation system used to recover the cost of most business property. Under GDS, assets are assigned specific recovery periods and depreciation methods. Often allowing faster write-offs than the Alternative Depreciation System (ADS). GDS is typically used unless the law requires ADS or the taxpayer elects otherwise.

Half-Year Convention (HY):

A depreciation rule that treats all property as if it were placed in service or disposed of at the midpoint of the tax year. This means you can claim half a year’s depreciation in the year the asset is first placed in service (regardless of the actual date) and, if held for the full recovery period, another half-year’s depreciation in the final year.

Indirect Cost:

An expense that benefits the overall property or multiple components but can’t be tied to one specific asset. In a cost segregation study, indirect costs (such as architect and engineering fees, contractor overhead, and profit) are allocated proportionally across the various asset classes identified in the analysis.

Land Improvement Property:

Tangible property added to or built on land that is not part of the building itself and can be depreciated for tax purposes. Examples include parking lots, sidewalks, landscaping, fences, lighting, and retaining walls. In a cost segregation study, land improvements are typically classified as 15-year property under the General Depreciation System (GDS) and may qualify for bonus depreciation.

Location Factor:

An adjustment applied to standard unit costs to reflect the construction or material cost differences in the specific geographic location of the property.

Mid-Month Convention (MM): 

A depreciation rule that treats property as being placed in service or disposed of at the midpoint of the month, regardless of the actual date. Under this convention, the MACRS deduction is prorated based on the number of months the asset is in service, with a half month of depreciation allowed for the month it is placed in service.

Mid-Quarter Convention (MQ):

Under this convention, all MACRS property placed in service or sold within the same quarter is assumed to have been in use for half of that quarter, regardless of the actual date.

Residual Cost:

The portion of a property’s cost assigned to Section 1245 assets that is subtracted from the total cost of the related Section 1250 property. This adjustment ensures that the value of 1245 property is not counted as part of the 1250 property’s basis.

Straight Line (SL):

A depreciation method that spreads an asset’s cost evenly over its useful life. To calculate, subtract the salvage value from the asset’s basis, then either divide by the useful life or multiply by the straight-line rate to determine the annual deduction.

Time Factor:

An adjustment that updates unit costs from their original source year to reflect pricing in the year the property was built or acquired.

Qualified Improvement Property (QIP):

Improvements made to the interior of an existing nonresidential building after it has been placed in service. QIP excludes enlargements, elevators or escalators, and internal structural framework. For tax purposes, QIP has a 15-year recovery period under the General Depreciation System (GDS) and is eligible for bonus depreciation if placed in service within applicable timeframes.

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Cost Segregation Study Terms Simplified

While the terms in this glossary cover many of the technical concepts found in a cost segregation study, the best understanding of tax terminology comes from experienced tax professionals and engineers who are trained on the language and the strategy behind it.

Think of this glossary as your trusty reference guide, helping you navigate your report with confidence and empowering you to ask the right questions, ensuring you get the full tax benefits for your real estate portfolio.

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